Which asset classes are considered ‘traditional’ and ‘alternative’ and what’s the difference?
Asset classes which commonly form part of an investment portfolio tend to be broken down into those considered to be ‘traditional’ and those grouped together as ‘alternatives’. Until around 10 years or so ago ‘alternatives’ were generally the reserve of institutional investors, with private investors largely limited to easy access to ‘traditional’ assets. In the intervening period, largely driven by the digitalisation of the investment industry, many alternative asset classes have now opened up to private investors.
Despite this, there is still a considerable level of confusion as to which assets are ‘traditional’ and which are considered to be ‘alternative’. While there is an academic debate on how asset classes are formed and defined, practically speaking the 1999 definition of Kritzman is probably closest to the reality:
“Some investments take on the status of an asset class simply because the managers of these assets promote them as an asset class. They believe that investors will be more inclined to allocate funds to their products if they are viewed as an asset class rather than merely as an investment strategy”.
It can be, I would say justifiably, argued that ‘alternatives’, were, and continue to be, referred to as such because the terminology implies a higher risk profile which suits the interests of the mainstream vendors of retail investment products such as equities and funds. Their diverse nature means that this is probably far too a simplistic categorisation and is not always the case. The debate around the classification of risk levels is not one which we will engage with here. Nonetheless, with mainstream investment managers such as pension funds now increasing their allocation to ‘alternatives’, and private investors increasingly able to access them as direct, stand-alone investments outside of retail investment funds, there is value in clarifying what kinds of investments fall into both asset classes, as most generally accepted. Many of these asset classes can also be further broken down into sub-categories but here we will treat them as their broader groupings. Neither list is exhaustive and covers only the biggest sub-categories within the two classes.
Traditional Asset Classes
- Publically-Listed Equities: shares in companies publically-listed on stock exchanges. Any individual or legal entity can, in theory, buy and sell publically listed equity if they have a stock broking account. This is a regulated market with all stakeholders from the companies themselves, the stock exchanges and various kinds of intermediaries having to adhere to strict rules set out by national regulatory bodies. In the UK this is the FCA. Investor capital is also ring-fenced so if their stock broker were to go bankrupt this would not lead to the loss of its client’s assets. In the worst case scenario of fraud, clients would still have their shares returned to them.
- Exchange-listed Bonds: different types of bonds can fall into the ‘alternatives’ class but exchange-listed bonds form part of the ‘traditional’ group of asset classes. There are many different kinds of bonds but the two main categories are government bonds, often referred to as ‘gilts’, and corporate bonds issued by companies. The main difference between equities and bonds is that when you buy equities you acquire an ownership stake in the company and when you buy a bond, you are buying debt, essentially loaning the company, or government, your money in return for an interest payment.
- Mutual Funds: these are publically listed investment vehicles that are typically equity-based but can also often include other kinds of assets such as bonds, cash equivalents and alternatives. Mutual funds can be considered to be something like an ‘off-the-shelf’, investment portfolio and their primary goal is to perform relatively better than the market. If equity markets are going up the mutual fund will hope to show slightly better returns than the market as a whole. If markets are losing value a mutual fund would also be expected to lose value, but relatively less than the market as a whole due to expert investment choices by its management.
- Real Estate: requires little explanation. Ownership to the title deeds of either residential or commercial property. REITs (Real Estate Investment Trusts) are also considered to be a traditional asset class and offer a hybrid model which provide the liquidity and smaller capital requirements of equity ownership with direct exposure to the real estate market.
Alternative Asset Classes
There is a large and quickly increasing set of investment instruments of varying levels of complexity roughly grouped together as ‘alternatives’. Here we will cover only the largest, most established of those.
- Hedge Funds: in contrast to mutual funds, hedge funds are private investment vehicles which are not exchange traded. They tend to have minimum periods during which investors’ capital is locked in. Hedge fund managers tend to employ derivative strategies which are much more complex than those of mutual funds and often employ the use of leveraged investments. Their investment strategies require more sophisticated risk management techniques but seek to generate excellent returns regardless of general market conditions. As such, they also have a higher risk profile and can lose significant sums of money. Investment in hedge funds is restricted to sophisticated and high net worth investors and they are not open to retail investors.
- Private Equity: there is no legal definition of private equity but private equity essentially invests in non-listed companies, acquiring them in their entirety or as one of multiple shareholders. The range of companies that private equity might invest in is the full spectrum from privately owned multinationals to small start-ups operating out of garages.
- Alternative Debt Finance: alternative finance is again a very broad ranging class that can be broken down into many sub-categories. Various kinds of corporate bonds are the most popular form of alternative debt finance. The principle is largely the same as investment in listed bonds with the main difference being that the investment capital is locked in for a set period of time and they cannot be sold on a public exchange. Because they are not listed on a public exchange, the issuing companies are also not required to publically release their accounts so investors are reliant upon their own judgement and the due diligence of the bond broker. Returns are usually significantly higher than those offered via exchange-listed bonds but if the company were to fail bond holders would potentially lose their capital if the assets the debt is secured against do not fully cover the total value of the company’s debt.
- Commodities: the purchase of commodities either through taking physical receipt of the commodities themselves, or through financial instruments such as derivative contracts and futures. This is a play on the price of the commodity rising, or falling if a short position has been taken. Unlike many other alternative asset categories, commodities and commodity-based derivatives can be traded on exchanges and can be considered relatively ‘liquid’ assets, though more niche commodities may not be.